US real estate miniseries #3 - foreign parent, domestic subsidiary

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Real estate investor mini-series, episode 3

Today is the third episode of a mini-series on real estate investment in the USA. The mini-series will cover federal estate tax and income tax on rent in four investment structures:

• Direct ownership by a nonresident alien individual;

• Direct ownership by a foreign corporation in a non-treaty country;

• A foreign corporation owns a U.S. corporation, which in turn owns the real estate (this week's episode); and

• Direct ownership by a foreign corporation in a treaty country.

The final episode will roll out next Friday.

Assumptions

You are a nonresident of the United States, and you want to invest in U.S. real property. You will collect rent from the real estate, and (you hope) sell the property in a few years with a nice capital gain.

To keep this miniseries shorter than an encyclopedia, let’s make these assumptions:

• Federal tax only. The math gets much simpler and the ideas are easier to explain when we only think about Federal income tax. Ignore state and city income taxes.

• Rent paid by the tenants is $100,000 per month (before expenses), or $1,200,000 per year. We assume these numbers in order to force the tax rates up to the highest marginal levels, and eliminate weird rules about phase-outs of exemptions and deductions.

• Operating expenses. Assume $400,000 of operating expenses (maintenance, property tax, mortgage interest, etc) and $300,000 of depreciation every year.

• Property value. The value of the real property is $10,000,000. This makes estate tax math simple.

• Home country income tax. I am ignoring income tax in your home country, in order to highlight the U.S. tax planning you need to do. Obviously, your home country income tax must be considered.

Previously

In the first episode, we looked at a simple idea: you own the U.S. real property directly.

The worst problem with this idea was the estate tax. If you die, there will be an estate tax risk of 40% of the value of the property. On a $10,000,000 property, that is a $4,000,000 tax that your heirs must pay. Not good.

The second episode looked at a legal structure that protects against estate tax: you own a non-U.S. corporation, and the corporation owns the U.S. real estate. This protects your heirs from the estate tax risk, but creates a horrible mess with the branch profits tax on the rental income.

This week we look at a slightly more complicated holding structure: you own the stock of a non-U.S. corporation, which in turn owns all of the stock of a U.S. corporation, which in turn owns the U.S. real estate. Let us see how that works.

Estate tax results: good

The results of the "use two corporations" structure is good for U.S. estate tax -- there will be no tax if you die.

The U.S. imposes a tax when people die. It is a tax based on wealth at the time of death, and is called the “estate tax”. IRC §§2101, 2103, 2106.

For a nonresident, look at what the individual owned at the date of death. Was that asset a “U.S. situs asset”? “U.S. situs” means “located in the United States, from the perspective of U.S. tax law”.

Shares of a foreign corporation are not U.S. situs assets. IRC §2104(a). It does not matter what the foreign corporation owns (even U.S. real estate). The individual owned the shares of a foreign corporation at the time of death, and these shares were not “in the United States”. There is nothing for the U.S. to tax.

By owning the shares of a foreign corporation, you remove a $4,000,000 estate tax risk if you die. It does not matter whether the foreign corporation owns U.S. real estate (the previous example) or owns a U.S. corporation that owns U.S. real estate (this week's structure).

Income tax: meh

There is nothing special about the way this domestic subsidiary calculates its corporate income tax as compared to the way any other domestic corporation calculates its normal corporate income tax.

Here is how it works (remember, these numbers are assumed for the purposes of this example):

• Start with $1,200,000 of rent income for the year.

• Subtract $400,000 for your expenses.

• Subtract $300,000 for the allowable depreciation deduction.

• You are left with $500,000 of taxable income.

• Now it is a multiplication job: find the corporate income tax rate in I.R.C. §11 and multiply your taxable income by that percentage.

The corporate income rate quickly averages to 34%. Let’s therefore roughly compute a corporate income tax of $170,000.

This means that the income tax on a domestic corporation's rental income is the same as a foreign corporation's income tax, and more or less the same as the income tax paid if you own the real estate directly.

Like last episode, let's call this a "Meh!"

Tax on dividends: not so good

So far, so good. The estate tax results are better than direct ownership, and the same as direct ownership of the real estate by a foreign corporation. The income tax on rent is the same (roughly) as the tax on rent if you owned the real estate directly, and is identical to the tax you would pay if the real estate was owned by a foreign corporation.

Now we come to the problems. Your U.S. corporation collects rent, pays its expenses, and pays tax. There is money left over, and you want it.

When the U.S. corporation distributes money to its shareholder (the foreign corporation), that money will be treated first as a dividend. And it will be taxed.

The default U.S. tax on dividends paid to nonresidents (including foreign corporations) is 30%.

The U.S. subsidiary had $500,000 of taxable income. It paid $170,000 of normal corporate income tax. If it pays $330,000 to the shareholder (the foreign corporation) as a dividend, will pay $99,000 of U.S. income tax.

Not surprisingly, this is the same as the branch profits tax that would have been paid (as shown last week in the example of a foreign corporation owning the rental real estate directly).

Personal holding company tax: worse

What if the U.S. corporation does not pay a dividend to its shareholder? Ahhh. The U.S. tax system has special pain to encourage you to change your mind. That special pain is the personal holding company tax.

This is a 20% tax on "undistributed personal holding company income"". IRC §541. It is designed to stop you from postponing the time that a dividend is paid. The U.S. tax system wants you to have taxable income and pay the 30% tax on dividends.

To be subject to this tax, the U.S. corporation must meet two requirements:

• it must be a personal holding company, and

• it must have undistributed personal holding company income.

The domestic subsidiary is a personal holding company

A corporation is a personal holding company if:

• 5 or fewer individuals own more than 50% of the value of the corporation’s stock, and

• 60% or more of the corporation's adjusted ordinary gross income for the taxable year is personal holding company income.

IRC §542(a).

Attribution rules for stock ownership apply -- these are complicated rules that treat you as the owner of stock (for tax purposes) even if the stock is owned by someone else. IRC §544.

You are the sole shareholder of the foreign corporation. The foreign corporation owns all of the stock of the U.S. corporation, and the attribution rules treat you as if you own the U.S. corporation stock. IRC §544(a)(1).

As a result, you are treated (for purposes of deciding if the U.S. corporation is a personal holding company) as if you own all shares of the U.S. corporation. Since the U.S. corporation is treated as if it has one shareholder (you), it satisfies the "five or fewer shareholders" requirement.

The "60% or more of income" requirement is also satisfied. Rent is a type of personal holding company income. IRC §543(a)(2). The U.S. corporation has only rent income -- nothing else. It satisfies the income test for being a personal holding company.

Both requirements are satisfied, and the U.S. corporation is a personal holding company and must pay the 20% personal holding company tax.

Personal holding company tax countermeasures

One obvious way to avoid the personal holding company tax is to fail one or both of the requirements:

• Fail the ""Five or Fewer Shareholders" Requirement. Have at least six shareholders for the foreign corporation. (Make sure that they are not too closely related so you do not run afoul of the attribution rules).

• Fail the "60% of Income" Requirement. Use your U.S. corporation for other business reasons, in addition to owning rental real estate. If, for instance, the U.S. corporation operates a small business that generates 45% of its income, then it will fail the "60% or more of income" test.

These ideas are interesting in theory, but not in reality. A real estate investor will usually have no desire to add outsiders to an investment. And someone who likes making real estate investments usually does not want to run an operating business as well.

The better countermeasure to the personal holding company tax problem is to not use corporations as holding vehicles for U.S. rental real estate. :-)

Eliminate personal holding company tax by paying dividends

The personal holding company tax is applied to undistributed personal holding company income. If the U.S. corporation makes distributions, then it will not have personal holding company income. And no personal holding company tax.

The U.S. corporation reduces its undistributed personal holding company income by distributing money to its shareholder (the foreign corporation) as dividends. IRC §§545(a), 561. If the U.S. corporation pays out dividends in the full amount of its personal holding company income, the math is indisputable: 20% of zero undistributed personal holding company income = zero tax.

And that, my friends, is what the U.S. government wants you to do. Incentives work. Tax pain or greater tax pain? You choose. :-)

Summary: expensive insurance against estate tax

By investing in U.S. real estate directly, you have an estate tax risk of about 40% of the value of the property -- about $4,000,000 in this example.

If you use a foreign corporation to hold the property, and you own the shares of the foreign parent, then you avoid the estate tax, but it comes at the cost of the branch profits tax.

If you use a foreign parent and a domestic subsidiary that holds the property, and you own shares of the foreign corporation, you also avoid the estate tax, but at the cost of a second layer of tax on a dividend, or by incurring the personal holding company tax.

Next week

Next week’s episode will continue the brief overview of holding structures. We will discuss how you can use income tax treaties to get better tax results.

Disclaimer

This is not tax advice to you specifically. It's damned complicated stuff to work with, and getting it wrong. Go find someone/something smart and have him/her/it help you.